Market Transactions

and

The Second Great Commandment

This analysis came out of a discussion on whether trading in a zero-sum
market like precious metals or corporate securities can occur in full compliance
with the Second Great Commandment, which Jesus
quoted from the Law of Moses:

"Love the Lord your God with all your heart and with all your
soul and with all your mind." This is the first and greatest commandment.
And the second is like it: "Love your neighbor as yourself." All the Law
and the Prophets hang on these two commandments. Matt.22:37-40

After giving it some thought, I came to the realization that while it is
easier to argue this point based on the observation that these markets
are inherently zero-sum, the point can be made without depending on
that contentious fact.

It was suggested to me that the analysis might be more easily understood
if arranged in the form of a syllogism. I have no particular reason to
believe that is true, but here it is anyway.

P1 Love the Lord your God with all your
heart and with all your soul and with all your mind. Moral Axiom

This is not a key component of the syllogism, but is included
to make the numbering more esthetic.

D1 "Love" as used in this Command (and P2)
means to willfully serve the best interests of the Person loved, as distinguished
from the warm fuzzy feeling of enjoyment common in modern usage.

With very few or no exceptions, this is the sense of "love"
in the Bible.

D2 "Neighbor" as used in this Commandment
is explained by Jesus in the Parable of the Good Samaritan [Luke 10:29-37]:
It is the nameless person (possibly a foreigner) you might encounter anywhere,
directly or indirectly, with the opportunity to make their life better.

We further note that while there are many people in the world
we can do something to help, this moral axiom commands us to serve their
best interests in like measure with our own, which is not accomplished
by giving everything to the poor. P2 is essentially
the Golden Rule, whatever we would want from somebody in like circumstance,
we should do to others.

D3 "Evaluation Formula" (or sometimes just
"formula") in this discussion means whatever combination of inferences,
calculations, and information from whatever source derived, regardless
of whether reasonable or irrational, reliable or merely statistical, by
which we assign a monetary value to some asset, product, or service, for
the purpose of comparing that value to some price and thus determining
whether to buy or sell it.

The point of this definition is to assign a numerical value
to the buy/sell decision. Most people implicitly make this calculation,
as in "You want $5 for this widget? That's a good price, I'll buy it."
-- meaning, their evaluation formula returns a value for the widget substantially
higher than $5 -- or perhaps "You couldn't pay me to take it" -- meaning
that their evaluation formula returns a large negative number.

The seller also computes an evaluation formula for the same widget,
and is willing to sell it when the formula returns a value less than the
price. Note that the buyer and seller usually (but not necessarily) use
different formulas. It is a requirement for the transaction to take place,
that the buyer's formula returns a value higher than the price, and the
seller's formula returns a value lower than the price. See below for examples
of evaluation formulas.

D4 "Differential Discriminating Formula"
(DDF) is a term I invented to refer to a single
evaluation formula which can be applied separately to the buyer's or seller's
personal values, skills, assets, and/or resources, to return a different
valuation in those two cases, so that the two computed values straddle
the price. The information and calculations are the same, the only difference
is its application to the personal data pertaining to one party or the
other. Where that data is unavailable for one or both parties and cannot
be reasonably estimated, it is assumed to be the same for both.

The point of this definition is to find some basis for all
of the information available to a particular party in the transaction to
yield a buy or sell decision based solely on what properly distinguishes
the buyer from the seller, and not on private or unfair information. This
is codified incompletely in the SEC proscriptions against "insider trading".

P3 A party to a transaction is in compliance
with the Second Great Commandment when that party knowingly uses a DDF
in determining the buy or sell decision.

Proof: To be in compliance P2
requires that the compliant party sees the transaction as serving the interests
of the buyer and seller (approximately) equally. Recognizing the different
stations in life, we do not require that the price be exactly in the middle
between the buyer's and seller's formula valuation, but that both buyer
and seller have a basis for believing that the transaction is profitable.
This much is necessarily true, or the transaction wouldn't take place at
all. P2 brings to the analysis the additional
requirement that the "You" (the person in compliance) knows that the "neighbor"
(the other party, from D2) is being fairly served,
that is, that the information available to the compliant party does not
put the other party at a disadvantage. This is accomplished by using a
single
evaluation formula applied separately to the two different parties, so
that when it is applied to the seller's skills and assets it yields a valuation
below the sell price, and when applied to the buyer's skills and assets
yields a valuation higher than the price.

Using any formula less than a D4DDF
to determine the buy/sell decision fails to comply with P2.
If the compliant party is not knowingly applying the DDF,
then it is not love as defined in D1. If the compliant
party reasonably assumes (from the fact that it is a willing transaction)
that the other party's (presumably different) formula informs his decision,
then it is not loving him "as yourself" (P2) because
the other party is not able to use the same information in that decision.
If the other party were using the same information, then it would necessarily
be a DDF from the definition D4.

Note that we do not require that both parties actually use
a DDF unless both parties wish to be in compliance
with P2. Nor do we require that both parties use
the same formula (whether DDF or otherwise). Thus
one party could use a DDF and be in compliance with
the Commandment, while the other party (perhaps using private information)
can believe he screwed the first party. Since there is also nothing in
D3
requiring the formulas to be accurate, it is further possible to be compliant
but mistaken about the benefit to the other party (or oneself, for that
matter) -- although of course we encourage due diligence to mitigate that
risk.

Note further that the fact of using a DDF to inform
one party's decision ensures that the other party's interests are being
served, even if that other party does not have all of the information available
for that DDF. Thus the DDF can
be applied in an anonymous transaction (such as a stock market buy or sell),
assuming that a DDF can in fact be formulated for
that transaction.

Evaluation Formula Examples

Note that some of these formulas are silly, others credible. That is completely
irrelevant to the definition, which only requires an evaluation formula
to be well-defined.

F1 (Wal-Mart trinket) The shelf-price
of the trinket at Wal-Mart.

This formula is not DDF, since it returns
the same value regardless of whether it is being considered for the buyer
or seller.

F2 (Wal-Mart trinket) The average of the
Angstrom wavelength of reflected light when white light is shined on it,
divided by 100.

This would give a valuation of $5 for red trinkets, and $3
for predominately blue ones. It is not DDF.

F3 (Wal-Mart trinket) The sum of the cost
(to the old or new owner, as the case may be) to manufacture it, plus the
marginal transportation cost from the place of acquisition to the place
of display, plus a SWAG esthetic value of $20 divided
by the number of trinkets on the display shelf.

F3 is a DDF (assuming
a shelf price higher than $4 and less than $120), because the cost to the
seller, who had it made in China for $1, is substantially less than the
$100 cost the housewife would have to pay in the USA to have it custom-made.
Furthermore, the $20 esthetic value is divided by 10 identical trinkets
on the Wal-Mart shelf, but by only 1 on the housewife's mantle. On the
other hand, Wal-Mart paid $0.10 in shipping for the trinket from China
to Texas, while the housewife's marginal transportation cost is $0 because
she was in the store already for other purchases, and it took no extra
gasoline to get it home. Therefore the valuation for the buyer, B=100+0+20,
which is substantially greater than for the seller, S=1+0.1+2.

F4 (Fence repair) The sum of the cost of
lumber and concrete needed to complete the repair, plus rental on a post-hole
digger, plus the value of the time of whoever does the job in dollars per
hour times the number of hours to do it.

F4 is a DDF for a contract price $800,
because while the materials and tool rental are the same (total $400),
the handyman labor is $15/hour for 12 hours, while the homeowner's labor
might be $40/hour for 25 hours. Thus for the buyer, B=$1400, while for
the seller, S=$580, nicely straddling the contract price.

F4 is a DDF, but that's not the formula the handyman
used to calculate his quote. Instead he used a rather simple formula:

F5 (Fence repair) The sum of the cost of
lumber and concrete needed to complete the repair, plus rental on a post-hole
digger ($400 for both), plus an estimated 12 hours at $20/hour for labor.

He might figure he screwed the owner because the price paid
is much greater than his formula F5 calculates it to
be. All that is pure profit for him. Thus, while the owner may have used
a DDF to decide to accept the contractor's bid, the
contractor did not use a DDF in deciding to offer
it. By F5 it was a win-lose transaction. If the owner
were to calculate his decision on F5, he would surely
have refused the bid and found another contractor who was not so eager
to gouge the customer.

Suppose instead the owner used a different formula to calculate whether
he was being offered a reasonable bid,

F6 (Fence repair) The sum of the cost of
lumber and concrete needed to complete the repair, plus rental on a post-hole
digger ($400 for both), plus an estimated 25 hours at $25/hour for labor.

As this is much greater than the price the contractor bid,
the owner got the best of him (that is, it was a win-lose transaction in
the owner's favor). The contractor did not make as much on this job as
he could have on other jobs he passed up to do this fence, and the owner
got off with a much cheaper fence than his calculations showed it should
cost. F6 is not DDF, but caveat
emptor! The owner made out OK. The fact that the contractor used F5
(which is also not DDF -- he grins all the way to
the bank) makes it "win-win" by the normal use of that term, but neither
F5
nor F6 is DDF, and neither party
is compliant with the Second Commandment, since both are of the (unspoken)
opinion that they screwed the other party.

F7 (stock on the market, per share) 0.001%
of the investor's net worth.

F7 is a DDF if the buyer
is wealthy and the seller is poor. It is not DDF if
the personal wealth of the two parties is the reverse or else if one or
both is unknown. This may be a silly example, but it shows that it is possible
to find a DDF in the stock market.

Extended example:

FarMac Corp has been making farm machinery for 20 years now. Their stock
is listed at P=$100 and stable.

Two recent events could affect the stock price: (a) The freeze over
most of the USA is likely to result in massive crop failures, and (b) FarMac
just hired the brilliant chief technical officer away from their major
competitor.

Two different investors look at this information and come up with different
evaluation formulas:

F8 Investor X figures that the farms are
covered by catastrophic weather insurance, resulting in extra cash on hand
for buying additional farm machinery, and the new CTO
will boost the technical innovation over the competitors, resulting in
better products and better profitability. Investor X calculates that the
increased sales and profitability should raise stock prices 20% over the
next year, which he determines to yield a NPV of +15%,
that is, the stock is actually worth $115 today. F8 makes
no distinction between buyer and seller, so it is not DDF.

F9 Investor Y was raised on a farm, and
he knows insurance does not cover the full force of the losses, so the
farmers will be hurting and unlikely to buy new machinery. Furthermore,
he knows that the new CTO was getting old and about
to retire, so he is unlikely to contribute much to corporate profitability.
Investor Y figures that the down market will depress the stock prices this
year by about 15%, yielding a NPV -10% or $90 in today's
dollars. F9 also makes no distinction between buyer and
seller, so again it is not DDF.

Scenario 1: The market is slow to react. In investor Y's formula
F9,
the calculated valuation V<P, so he decides to sell his 100 shares at
market price ($100) and buy them back at the end of the year, for a net
profit estimated to be $2000. Investor X's formula
F8
yields a calculated valuation V>P, so he decides to buy 100 shares at market
price and expects to realize a $2000 profit when he sells then at the end
of the year. X ends up buying Y's shares for $100.

From D4, the definition of DDF,
we can see that neither F8 nor F9 are
DDF.
Consider instead,

Scenario 2: The market over-reacts to the weather, and the share
price drops overnight to $70. This is below the value determined by F9,
so investor Y decides to buy 200 shares instead of selling, because he
knows that when the market recovers its senses by the end of the year,
the price will rise back up to $85 he has calculated, so selling his shares
at that time will yield a net profit. Notice that calculated valuation
V for investor Y's F9 is the same for buyer and seller.
When V>P he buys, and when V<P he sells. That is the nature of an evaluation
formula.

I leave as an exercise to the reader, to come up with a DDF
for a typical stock market transaction, or else to explain why that might
not be possible.

I invite comments
and criticisms for the purpose of better understanding what kinds of
transactions serve the Golden Rule.

Tom Pittman
First draft 2007 February 12

The fellow who invited me to present this analysis tells me that everybody
else disagrees with me on the outcome. Those people are obviously smarter
than I am: they know that if they tell him the truth, he will blow them
off with exceeding great hostility and venom, so they only tell him what
he wants to hear. sigh